Genetic Mimicking Portfolios for ETF Arbitrage

Financial markets are full of securities whose price depends on other securities that are often difficult to trade. We develop a method to identify a liquid mimicking portfolio that tracks a de facto non-tradable asset. Our method combines a genetic algorithm with non-negative least squares. We apply it to the corporate ETF market. An arbitrage portfolio that takes a short position in the ETF with the highest price relative to its net asset value and a long position in the mimicking portfolio generates a Sharpe ratio of 3. The return on the mimicking portfolio correlates negatively with the return on the short position, is responsible for about one-third of the Sharpe ratio, and reduces expected tail loss by two-thirds.